If a company is too small to be listed on the
NYSE or NASDAQ stock exchange, it can trade through the Bulletin Board or Pink Sheets electronic quotation systems. The equities that are traded are known as penny stocks. These stocks trade below $5 a share.
There is much discussion about the pros and cons of penny stocks. Let’s face it, we’ve all heard the stories of rags to riches in the investment world. More often than not, these stories come from some sort of transaction involving a penny stock. We’ve all probably seen Wolf of Wall Street, but we all can’t be Jordan Belfort. Most of the people who choose to go down that path will only find their bank accounts and morale severely depleted.
That being said, if you are comfortable with taking on a substantial amount of risk, there are some benefits to penny stocks. There seem to be two types of sites on the Internet these days. Those who preach penny stocks and show videos of the trader strutting through their million dollar mansions, and those who practically classify penny stocks as a version of the bubonic plague. There has to be a middle ground right? In this article, I will weigh the pros and cons of investing in penny stocks so you can really decide what’s best for you.
The pros of investing in penny stocks
The possibility of a massive payday
Just like gambling in a casino, the possibility of hitting it big is always there when you are trading for pennies. Just like a poker player can gain a definitive edge over the rest of the table at the casino, you too can at least tilt the odds in your favor with proper research of penny stocks and penny stock companies.
Increased volatility makes for quicker returns
Typically when you invest in a growth stock on the TSX or the NYSE, you’re looking to see some growth over the next 1,2 or even maybe even 5 years if you’ve got the patience. You can see exponential growth from investing in penny stocks in a matter of days, and sometimes even hours. Obviously, this works the other way, but we will leave that for the cons section.
Not all penny stock companies are poorly managed
A lot of naysayers towards the penny stock industry believe most all companies that trade on the pink are poorly managed and have poor financial evaluations. This couldn’t be farther from the truth. There are a ton of solid small companies that simply are not big enough yet to trade on the big exchanges and have promising financial statements. This is what can separate good from poor penny stock investors, finding these diamonds in the rough.
These stocks are cheap, and I mean real cheap
A “penny stock” isn’t necessarily trading for pennies. The stock price for these stocks can be anything below $5. If you’re looking to clear the waters on the true definition, check out this guide on penny stocks. With all that being said, the large majority of penny stocks will be trading in pennies. This allows investors to purchase large amounts of stocks at a relatively low price.
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The Cons Of Investing In Penny Stocks
The possibility of an empty bank account
Trading penny stocks is risky. In fact, these stocks are often too risky for people’s tolerance. The volatility of the vast majority of penny stocks is enough to make even the strongest person nauseous. You must be willing to take the lows with the highs and learn to cut your losses. You’re not going to win every trade. In fact, you’ll probably lose the large majority of them in this industry. The idea is to limit your losses to the point where your wins cover the cost of them and then some.
It’s very, very hard to find accurate information about these companies
One of the rules for being listed on an exchange like the TSX or the NYSE is the fact that you must submit financial reports and earnings. Unfortunately, companies trading penny stocks to a large degree are not required to do so. Therefore, you’re either trading fundamentally blind and relying purely on technical indicators, or just guessing. Digging for financial documents on pink sheet companies can take a big shovel, and even then you may come up empty.
Scams are everywhere
You will find penny stock scams all over the place. The pump and dump, the short and distort.
- Pump and dump schemes are where stock promoters drum up support for stock. Once stock has reached an inflated price the promoters sell or dump it and the investors are left with nothing to show for their investment. These pump and dumps are common.
- Shorting is when an investor borrows shares and sells them at a high price on the open market hoping that the share price will drop and they will be able to buy them back at a lower price. When this happens they return the shares to the lender and make a profit.
The fact that these stocks are so thinly traded means that it takes substantially less action to have a deep effect on the stock. Beware when signing up for penny stock newsletters and stick to reputable ones. These newsletters may be trapping readers into a scam by buying up a ton of the stock, promoting it in a way that affects the movement and then selling off for a massive profit while you go home empty-handed.
Commission costs could cost you a ton
Most brokerages charge a fairly streamlined commission for Motley Fool stock picks on indexes such as the NYSE. For penny stocks, there is often a substantially higher commission charge. Be aware of this before you sign up as it could cost you dearly. One broker that doesn’t raise commissions for penny stock trading is Questrade.
Summing it all up
This obviously isn’t the be all end all of penny stock trading advice. I’m simply weighing the options on both sides of the table and letting you make the decision. I personally do not trade penny stocks and probably never will, but this isn’t because I think there isn’t profit to be made. There are numerous successful penny stock traders out there and their stories highlight hard work, dedication and a knowledge of the markets and the risks within. I don’t trade them because I am just not comfortable with the risk. I hope this article helped you, and feel free to ask any questions in the comments section below!
Author Bio: Dan Kent is a writer and co founder of Stocktrades.ca. A DIY investor for 7 years now, Dan has a combination of dividend, growth and real estate investments in to his portfolio and is looking to continually grow his net worth. You can check his website out at stocktrades.ca or follow him on Twitter at @Stocktrades_CA.